Delay Penalty in Construction Contracts

No construction project is risk-free. Risk can be managed, minimized, shared, transferred or accepted. It cannot be ignored

-Michael Latham

Scope and usage of back-to-back contracts

Back-to-back contracts are becoming an increasingly common feature of construction projects. Construction projects typically involve the collaboration of three parties at different levels: employer, main contractor and subcontractor. The employer prefers to enter into only one contract with a single party (the main contractor) which will act as a single point of responsibility regarding the project. However, in order to complete the project effectively and on time, the main contractor hires a number of subcontractors to perform specific tasks as part of the overall project. Subcontracting is permissible under the UAE Civil Code[i]unless the contract between the employer and the contractor prohibits so[ii]. Accordingly, the main contractor concludes separate contracts with subcontractors who carry out the work according to the specifications indicated in the main contract.

Although there is no direct contractual link between the employer and the subcontractor, the main contractor, having assumed responsibility for all aspects of the project vis-à-vis the employer, will pass on its obligations and liabilities to its subcontractors through a contractual arrangement known as a back-to-back agreement. Note that even though the main contractor may have entrusted the performance of the whole or part of the work to a subcontractor, he remains responsible towards the employer for the whole of the work[iii]. This responsibility is reinforced by clause 4.4 of Fédération Internationale des Ingénieurs-Conseils (the FIDIC) Red book 1999 which stipulates that “the Contractor shall be responsible for the acts or defaults of any Subcontractor, his agents or employees as if they were the acts or defaults of the Contractor”.

So what are back-to-back agreements? Back-to-back agreements refer to the duplication of terms and conditions in a contract at different levels of the project.

While back-to-back agreements are said to be very convenient and time efficient, they can create complex issues at a later stage as a result of poor drafting. Poorly drafted contracts can be difficult to interpret and can give rise to time-consuming, expensive disputes[iv]. This article seeks to discuss the different approaches that one can adopt while drafting a back-to-back agreement and will throw light upon some clauses which require careful consideration and appropriate drafting.

Structuring Back-to-Back Contracts

Drafting a back-to-back contract is not an easy task. It requires careful consideration as to which specific terms shall be passed down the chain as part of this arrangement. There are two ways of structuring a back-to-back contract:

Incorporation by Reference

Incorporating particular terms of the main contract by reference and expressly excluding or varying other terms (e.g. those relating to price). In other words, the main contractor simply mentions in the subcontract that the terms of the main contract are applicable to him and the subcontractor. However, in some jurisdictions, simple references are not recognized by courts. In a Scottish case of Watson Building Services Ltd v Harrison, the court refused to apply a condition laid out by the main contractor for making simple references to the terms of the main contract clauses.

Although the approach incorporation by reference might seem very convenient to the parties as it saves time and is cost-effective, all that glitter is not gold. Such an approach can result in ambiguity and limit the main contractor’s attempts to pass down risks to the subcontractor. For instance, a provision stating that “all references in the main contract to the ‘Employer’ and ‘Main Contractor’ are to be read in the subcontract as being references to the ‘Main Contractor’ and ‘Subcontractor’ respectively”, may not be appropriate for every obligation. The clause is unclear as to what terms of the main contract which have or have not been incorporated in the subcontract. This could result in rendering an essential term of the contract either ineffective or subject to an interpretation that was never intended by the parties.

In the above Scottish case, the subcontract provided that “this sub-contract is placed with your subject by and large to the same terms and conditions as the main contract”. The respective judge held that the wording “’by and large’ is anybody’s guess and anybody’s guess is likely to be wrong and it is not for me to guess which clauses of the main contract are to be ‘by and large’ incorporated [in the subcontract]”. Accordingly, such provisions may not achieve the intended purposes of a back to back agreement.

Adopting this approach without enough care and caution can create greater problems than originally thought. The drafters should be very careful, as it can be very complicated to identify every single clause in the main contract that is relevant for the subcontract. This eventually calls for cross-referencing between the main contract and subcontract. Similarly, where there are long and detailed main contract specifications, it can be very complicated for the subcontractors to separate the relevant clauses from the irrelevant ones. The subcontractors can be subject to risk by taking on matters that are inappropriate given the size and scope of their particular subcontract.

Hence, it is very important that the clauses to be adopted in the subcontract from the main contract are clear in demonstrating that the parties meant to incorporate the particular clause/(s). An example can be “the following [clauses of the main contract] shall be deemed to form and be read and construed as part of the subcontract”. Further, these issues can also be managed to a certain extent by drafting a stand-alone contract discussed below.

Stand-alone contracts

A stand-alone contract is achieved by drafting independent terms specifically tailored for the subcontract. The benefit of this approach is that while executing subcontracts the parties need not cross-refer the main contracts for every clause and clarification. They only need to adhere to the provisions of the main contract defining the relationships of actual parties to the project.

On the other hand, drafting a standalone agreement is not an easier task. Considerable care should be taken while drafting so that only the correct terms are passed on to the subcontract and they shall be phrased accordingly. Drafters shall also make sure that the provisions especially relating to timings, payment terms, exclusion of liabilities on subcontractors, termination, and compensation are properly coordinated between the contracts at different levels.

Common Drafting Issues

Irrespective of the type of drafting method that drafters opt for, there are several issues that require our attention:-

Terms of Payment

Care needs to be taken when drafting a general back-to-back clause with respect to payment terms. Consider a situation where a back-to-back provision provides terms of payment as mentioned in the main contract. Now, that can be read as Pay when paid and/or Pay if paid. In many jurisdictions, such as England and Wales, conditional payment provisions are not enforceable in construction contracts[v].

In our view, it is unfair for a subcontractor to not get paid for completed work due to the main contractor not being paid by the original employer. In the UAE, conditional payment clauses are valid and enforceable, whenever there are such agreements between the parties. However, in many UAE court judgments, it is provided that the main contractor shall be responsible for the act of the subcontractor; and that the subcontractor shall be paid by the main contractor once he finishes his work. This is irrespective of whether the main contractor has finished his work or not, or received his payment from the employer or not.

In the Court of Cassation Case Number 281/95, the subcontractor had finished his work and the contract stated that “any payment to the subcontractor would only be due and payable at the time that the payment is received by the main contractor from its client”. The Dubai Court of Cassation held that “the sub-contractor will only be entitled to a proportional payment during the performance period from any payment received by the main contractor from its client, the same does not apply when a sub-contractor has completed all his work and delivered the project to the main contractor. A sub-contractor has no obligation to wait for payment until such time as the main contractor has been paid”.

Moreover, subcontractors generally do not wish to get into such clauses, as they expect payment as soon as they have completed the work as per the subcontract. It is also not advisable for subcontractors to accept back-to-back payment terms because they contain a high risk of the subcontractor not being paid. Very often main contractors are not paid by the employer. Sometimes employers face financial issues leading lack of payment to the main contractor. A subcontractor should, therefore, attempt to negotiate the removal of back-to-back payment terms under a proposed agreement. If this is not possible, the subcontractor should negotiate a modification of such back-to-back payment terms or provide for some exceptions. For instance, a subcontractor could accept back-to-back payment terms with the following exceptions:

i. When the main contractor breaches its obligations towards the employer and the subcontractor had no association with the breach;

ii. Where the employer was refusing payment to the main contractor for no apparent reason, such as if there were no legitimate force majeure events preventing the employer from making payment to the main contractor

Contractual deadlines

It is essential to make sure all deadlines in subcontracts are coordinated with deadlines of the main contract. This may include, but is not limited to, the material and shop drawings submittal dates, claims notification periods, completion dates, notices, and delivery. Clause 20.1 of FIDIC provides that a contractor must give notice within 28 days of an event if he considers himself entitled for extra cost or money.

The drafters should ensure that the deadlines in the subcontract are shorter in duration than in the main contract. The subcontractor must, in turn, allow his subcontractors (if any) an even shorter period. This is to allow the main contractor time for inspection and corrections before the original deadline reaches under the main contract.

Also, the provisions of notice of default will require a thorough review. Gaps in the claims procedures across the two contracts are risky to main contractors. This is because in main contracts the main contractor's right to claim in full against the employer will be subject to complying with the main contract notice requirements. Those notice requirements should be adequately reflected in the subcontract.

Termination

The termination of the main contract for any reason shall terminate the subcontract as well. The drafters shall clearly provide that in the event of a suspension or termination of the main contract, the subcontracted work will be suspended or terminated similarly.

Clause 15.5 of FIDIC introduces termination by employer for convenience, which enables the employer to terminate the main contractor agreement at any time. If the subcontract does not incorporate such a clause, the main contractor will find himself liable to the subcontractor. Similarly, the subcontract shall provide that “in the event of termination, the subcontractor should have no claim against the main contractor except where the breach on the part of the main contractor gave rise to the suspension or termination. However, any such termination should be performed in good faith as per Article 246 of the UAE Civil Code, i.e. without prejudicing the rights and entitlements of the subcontractor. The drafters shall provide, in particular, that “subcontractors shall be entitled to certain compensation for loss and damages if the termination of the main contract came as a direct result of the main contractor.

In a back-to-back arrangement, any dispute arising between the employer and the main contractor is consequently reflected in the relationship between the main contractor and subcontractor and vice versa. Depending on the nature of the subcontract, claims that usually go up and down the chain relate to defects, performance, failures, variations, and delays.

In all cases, the main contractor would like to make sure that he is not exposed to a liability regarding matters which are outside of his control, which, in turn, cannot be passed on to the subcontractor. The major concern for the main contractor will be to ensure that he is not subject to different judgments by different tribunals constituted under two different contracts with the employer and subcontractor at various levels in a project.

To avoid this, drafters should make sure to incorporate such terms in the subcontract like: “the parties agree to cooperate with each other to resolve the main contract dispute first; and that the subcontractor shall stay the dispute with the main contractor under the subcontract until the main contract dispute is resolved. Such a provision may help in better dispute resolution.

Furthermore, dispute resolution terms cannot be incorporated by reference to the main contract conditions[vi]. The arbitration clause shall be in writing[vii] and cannot be back-to-back.

Conclusion

To conclude, back-to-back contracts can be effective in construction projects, provided they are handled and drafted with care. It is important to be aware of the risks associated with the use of this technique. There is no one-stop shop solution for various drawbacks associated with back-to-back arrangements. However, whatever approach to drafting a back-to-back contract is taken, the parties should ensure that the subcontract is properly drafted. Drafters should, in turn, make sure that each term incorporated into the subcontract by way of back-to-back arrangement has the result intended by the parties. In any case prices, deadlines, termination and dispute resolution must be agreed separately for each case, and drafters should pay special attention to circumstances related to these issues.

i. All references to articles are references to the UAE Federal Law No.5 of 1985 (the Civil Code), unless provided otherwise.

iv. Bringtin Engineering Ltd. v Cheerise Asia Ltd.

v. Section 113 of the UK Housing Grants, Construction and Regeneration Act 1996